Initial Public Offering

An initial public offering (IPO) occurs when a firm for the first time sells securities to the public. Firms going public can be nascent start-ups or old, established corporations engaged in restructuring programs requiring new capital injection. The IPO as a means by which capital is raised became an increasingly common phenomenon in the 1990s when more than 4,000 IPOs were issued in the United States alone.

The process for conducting an IPO generally involves a firm taking the following steps: (1) it registers with the Securities and Exchange Commission (SEC), (2) it seeks the help of one or more investment banks as “underwriters” to pursue a coterie of institutional investors and the general public to purchase the firm's stock, (3) it presents the IPO fact file and prospects to the investor community, (4) it determines the number and price of shares to be offered in the IPO, and (5) it works out the aftermarket position, after observing the “quiet period.”

There are a wide variety of reasons for a firm's decision to go public. As the IPO firm faces lower costs for external equity, going public means a lowering of the cost of capital. Moreover, while an IPO broadens the ownership base of the firm, it also allows insiders to cash out. Founder managers, and, in some instances, financial intermediaries such as venture capital and private equity firms can then harvest their investment. Since an IPO attracts the attention of a wider market, a firm operating in a sector such as high technology may conduct its IPO as a reputation-enhancing move. It is also suggested that when a firm reaches a certain point in the business growth cycle and needs capital to support growth, it will decide to conduct an IPO.

The timing of an IPO is deemed crucial because it is generally observed that IPOs come in waves. There are signs of herd mentality in such behaviors, as first-day stock performance of an issuing firm is likely to lead other firms to decide to go public. Firms can then take advantage of better stock market conditions by entering the IPO market. To the extent that the market timing issue is important, a firm will first need to gauge the strength of the IPO market in terms of market and industry stock returns.

There is a difficulty relating to price discovery in an IPO, which is due to the fact that the issuing firm lacks information about the investor demand for its shares, whereas most investors are not certain about the quality of the firm. Therefore, the IPO firm's value must be established without referring to the market value. To alleviate such problems of information asymmetry, investors use a number of mechanisms that signal firm quality. One such mechanism is the choice of underwriters, who have strong incentive to build a reputation as valuation experts as they repeatedly bring firms public. Underwriters are also expected to have an institutional client base, as institutional investors are more willing to participate in an IPO when there is uncertainty about the IPO firm.

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